Korean Scramble: Who Will Buy KAI?

Unlike most countries of its size, when South Korea wants to build a military aircraft locally, it has two aerospace manufacturers to choose from.

In an increasingly concentrated global industry, this state of affairs has perhaps been unnatural. So it is not surprising that one of the companies, Korean Air Lines, has long wanted to buy the other, Korea Aerospace Industries (KAI).

The quarry has evaded its hunter for nine years. But with an outgoing presidential administration keen to sell its stake in KAI before leaving office in February, the company's number may finally be up.

Or maybe it is not. Originally the only bidder, Korean Air finds that Hyundai Heavy Industries has made a surprise competing bid for KAI. Definitive bids should be lodged in November after a month of due-diligence investigations of KAI, which now seems certain to lose its independence. Its managers must be hoping for the company to become a unit of Hyundai Heavy, since KAI and Korean Air's Aerospace Div. have a reputation in the industry for loathing each other.

The defense ministry is also probably hoping that Hyundai Heavy wins, to preserve competition in a country that tries harder than most to spend its defense budget at home.

Hyundai's reason for bidding for KAI is unknown, but the government reportedly urged it and other conglomerates to do so. They were reluctant because of widespread complaints that they already own so much of the economy. It is not hard to imagine Hyundai wanting to emulate Japanese heavy-industry companies that have aerospace divisions.

Korean Air openly wants to put an end to competition. Fierce rivalry has hurt the profitability of both companies, says Choi June-chul, head of Korean Air's Aerospace Div., explaining to South Korean media why it should be allowed to take over KAI.

Certainly the combined group would have much greater pricing power when foreign customers such as Airbus and Boeing seek South Korean suppliers, says an adviser to a company involved in the deal. Another result, also common in almost any industrial takeover, would be to economize on overheads and to optimize use of costly machinery, in part by avoiding duplication.

If Korean Air wins, the government would probably forbid reorganization of the two groups for two years, says the adviser. Choi suggests the two companies would be operated indefinitely as separate subsidiaries. The advantage of doing so is not clear, except that it would help mollify KAI's managers.

A combined group, being larger, would be more competitive on the world stage; that was one reason why, four years ago, China began grouping together aeronautics plants that regarded each other as rivals.

Even a cursory look at the two South Korean companies shows they lack the scale of leading aerospace groups, even by the standards of the country's neighbors. KAI's sales last year were 1.29 trillion won ($1.15 billion). Korean Air's Aerospace Div. is much smaller, with revenues of around 550 billion won last year. By comparison, Mitsubishi Heavy Industries reported aerospace sales of ¥495.9 billion ($6.38 billion) for the year to March 31.

Remarks by Yoo Seongmin, an influential member of parliament who could be defense minister within months, have hinted that the defense ministry is worried about ending up with a monopoly supplier but has been bureaucratically bypassed. The departments driving the sale are the finance ministry and the ministry of knowledge economy, as the industry ministry is known. They “recklessly want to sell KAI without asking the opinion of the defense ministry,” Yoo says.

He is expected to become defense minister if Park Geunhye of the ruling Saenuri Party wins the election. That should unnerve the whole industry and the bureaucrats that seek to guide and promote it, since his public statements show that he puts their interests well behind those of national security. “Weapons are for fighting and winning wars, not for developing an export industry or for serving as a new engine for economic growth,” he told parliament last year. He is also opposed to indigenously developing a stealth fighter under the KF-X program, arguing instead for cheaper imports (AW&ST Sept. 24, p. 30).

To some extent, Korean Air Aerospace and KAI have become complementary rather than competitive suppliers to the defense forces. KAI is the country's fast-jet builder and seems to have been anointed as the national rotary-wing specialist, while drone programs are now consistently assigned to Korean Air. Also, KAI has a much larger design office and therefore the greater capability for in-house development.

Both companies rely heavily on manufacturing of parts for Airbus and Boeing civil programs, but defense accounts for almost 60% of KAI's business. Hyundai Heavy, separate from but related to Hyundai Motor, has diversified activities such as shipbuilding and oil refining. The conglomerate that spawned them contributed its aerospace division to the formation of KAI.

The size of South Korea's economy highlights the anomaly of the country having two aircraft builders. Japan has three to choose from, but only by carefully nurturing them at great public expense, and its economy is more than five times as large as South Korea's. Australia, also with an economy larger than South Korea, is not much interested in such nurturing at all; no company there can fully build aircraft, apart from simple general aviation types.

KAI has willing sellers as well as a willing buyer. Four groups, led by the government's Korea Finance Corp., are offering a combined 42% stake in the company. The administration of President Lee Myung-bak has put Korea Finance under pressure to sell state assets before he leaves office, because that is what he promised before his election five years ago. The other three big shareholders, all private and including Hyundai Motor, propose to sell jointly with Korea Finance. Lacking much reason to own stakes in an aircraft builder, they have been waiting for such a chance. Under South Korean law, only local investors can buy the stake.

A person involved in the deal and familiar with Korean Air's thinking says it will never pay anything like the market price, which last week valued KAI's equity at 2.5 trillion won.

While noting that the company is highly priced compared with foreign aerospace manufacturers, such as Boeing, equities analysts at Nomura say that “KAI has a better growth outlook for the next five years, in our view.” It is unclear why KAI should be expected to grow strongly, however. Its civil work will presumably expand only in line with global commercial aircraft demand. As for defense, its biggest new program—to build the 245 Surion utility helicopters—will run at a modest building rate over roughly 10 years. The prospective Korean Attack Helicopter program, not yet launched, will have a similarly drawn-out production profile. Like any national arms supplier, its prospects for revenue and profits are very much in the hands of its defense-ministry customer.

One reason for the high price of the shares could simply be patriotism among South Korean investors, combined with the small fraction of the company's stock that is freely traded.

Until the Asian financial crisis of 1997-98 forced reorganization, South Korea had four aircraft manufacturers: the aerospace divisions of the Samsung, Hyundai and Daewoo conglomerates, which were merged to make KAI, plus Korean Air. Korean Air was able to resist a government push to include its aerospace business in KAI, too—presumably because Korean Air would have been only a minority shareholder.